Amine Ouazad Microeconomics C Where are we Bayesian games aka games with imperfection information Adverse selection George A Akerlof Solution 1 Screening Joseph E Stiglitz ID: 330489
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Slide1
Adverse Selection
Amine Ouazad
Microeconomics CSlide2
Where are we?
Bayesian games.
a.k.a
games with imperfection information.Adverse selection.George A. Akerlof.Solution #1: Screening.Joseph E. Stiglitz.Solution #2: Signaling.A. Michael Spence.Common thread:Information is imperfect. Information is asymmetric.Slide3
Outline
Markets with asymmetric information
Insurance premiums
Mortgage Backed SecuritiesThe market for used carsMarket for LemonsAkerlof’s “The Market for Lemons: Quality Uncertainty and the Market Mechanism.”Empirical Evidence of the Market for Lemons.Slide4
Asymmetric Information:
Insurance premiums
(healthcare/car insurance)
Probability of a medical condition is p. Cost of medical treatment is c. Fixed cost of handling the patient is FC. Medical insurance covers x percent of the medical costs.A profitable insurer sets a premium?Role of competition in the healthcare industry?Solution? Forecasting exercise.Preexisting medical conditions. (Stronger problem with age).Age, gender, genetic determinants.Unobservability of the probability of a medical condition.Legal constraints: use of some variables is constrained by law.Technological constraints: variables cannot be observed using current technology or due to contracting problems (sport, diet).Slide5
Mortgage Backed Securities
Borrower has a risk of default of p, receives a loan l, and makes mortgage payments
m. Value of the collateral is C.
Value of the mortgage to the originator?Observability of the risk of default?Credit score (FICO Score of the applicant)Income, geographic location.Value of the collateral?Use of Zillow.com, Multiple Listing Services, Case Shiller survey.Unobservability of the risk of default:Legal constraints: gender and race cannot be used in pricing mortgages. But interest rates are shown to depend on them (negotiation process).Technological constraint: relevant information is not available – income is transitory or permanent.Credit score is not sufficient to characterize the risk of default !
Originator
Conduit
Bank
Accounts receivables
Cash $
Capital
Loan repayment
Securitization processSlide6
Asymmetric information,
adverse selection, and the financial crisis.
“They structured like mad and travelled the world, and worked their tails to make
some lemonade from some big old lemons.”- Former head of Goldman Sachs’ mortgage department in an internal email released during the U.S. Senate Permanent Subcommittee on Investigations hearings of April 27, 2010.Slide7
2. Market for Lemons
Homogeneous goods | observables
v
s Unobservable quality.Goods of a grade, e.g. commodities.Goods of different grades/qualities, e.g. used cars, wine, mortgages/loans (Stiglitz: banks as holders of information about consumers/collaterals), some agricultural products.Typically observable information is not sufficient to define the product’s quality.Used cars?Maintenance records. Electronic record of driving habits.Visual inspection.Old common law doctrine of caveat emptor.Buyer required to perform due diligence.But experience needed. Seller can also tamper with odometer, etc.FTC’s Trade Regulation Rule concerning the Sale of Used Motor Vehicles.Slide8
Market for Lemons
Good is a good car with probability q.
A lemon with probability 1-q.
Also proportion of lemons and good cars.Asymmetric information between seller and buyer?Valuation of a car for the buyer/the seller?One single price?What is the equilibrium of the market?Understand this in the context ofHealthcare? Mortgage Backed Securities? Reverse mortgages? Life insurance?Slide9
Market for Lemons
Such result may be due to the simple “2-type” model.Slide10Slide11Slide12Slide13
Supply and demand diagram
B. Asymmetric informationSlide14Slide15
Supply and demand diagram
C. Symmetric informationSlide16
Exercises
Write the “market” for lemons for insurance premiums using the previous framework.
Discuss the assumption of risk neutrality. Why doesn’t a voluntary healthcare market collapse?
Same question with Mortgage Backed Securities.Slide17
Development of institutions and mechanisms
Institutions developed in reaction to the adverse selection problem:
Mandatory health insurance. Mutualization of risk, where some individuals overpay and others underpay.
Britain, France, Spain, Austria, Belgium, Germany.US: Patient protection and affordable care act (2010), with mandatory health insurance (but little enforcement). Before, typically employer-provided health insurance plans.“Premium” used cars guaranteed by the dealer, with extended guarantees. ➭Signaling session #4.Menus of choices such that individuals self-select into the choices.➭Screening session #3.Slide18
Markets where “Trust” is important (conclusion, page 500)Slide19
Next session:
Bayesian games.
a.k.a
games with imperfection information.Adverse selection.George A. Akerlof.Uninformed party’s solution: Screening.Joseph E. Stiglitz.Informed party’s solution: Signaling.A. Michael Spence.Common thread:Information is imperfect. Information is asymmetric.